12.2. Basics of Economic and Financial Analysis

Economic and financial analysis can inform decisions at the project identification and preparation stages by contributing to strategic choices for offering specific levels of service. These analyses are essential for designing appropriately scaled, cost-effective projects as well as avoiding unnecessary costs of delay and unwise investment. Key areas for analysis are the demand for different levels of service, the use and targeting of public subsidies, and how to reform tariffs and improve utility finances Both economic and financial appraisal are vital parts of project monitoring and evaluation (URL 1). At the same time, economic and financial analyses are clearly distinguished with respect to analytical perspective. Economic analysis considers benefits and costs of a project for the society as a whole and compares alternatives that address an identified problem and objective. Each alternative is analyzed using the same period of analysis and baseline conditions. Financial analysis should be completed if the economic analysis demonstrates that the project is justified. A financial analysis is concerned mostly with a project’s ability to generate enough revenues to pay back financial costs incurred in facility construction and operation (Souza et al. 2011). Therefore, distinction between financial and economic analysis is an important for the project. For example, if the financial and economic boundaries of a project are the same, as in public utility projects differences between financial and economic returns come down to differences between financial and economic prices. The main differences between the economic and financial values of project costs and benefits (Nielsen, 2005). Because, for instance, when calculating the discount rate, inflation is included in financial analysis, which uses nominal prices. Discount rates are used in economic analysis to convert benefit and revenue streams to monetary units of a year of reference thus real prices in economic analysis excludes inflationary effects, but accounts for individual price changes. Similarly, the marginal cost of raw water comprises not only the investment and operation and maintance costs calculated as average incremental cost, but also the opportunity cost of water. The opportunity cost of water is the benefit forgone in the next best alternatives of water. On the benefit side, financial benefits may include both quantifiable and nonquantifiable benefits associated with water from alternative sources being displaced by the project, and new and additional sources of supply becoming available (ADB, 1998). But both approaches include an evaluating process for each alternative then compared to the “without project” scenario, the alternatives are ranked, and the best alternative is selected (Souza et al. 2011).

Table 12.1 Key Aspects of Economic and Financial Analyses

The basic framework of the financial and economic analysis is given below (Figure 12.1) in accordance with Table 12.1.

Figure 12.1 Economic and Financial Analysis of a Project Alternative (Souza et al. 2011)